Subprime lending
Encyclopedia
In finance
, subprime lending (also referred to as near-prime, non-prime, and second-chance lending) means making loan
s to people who may have difficulty maintaining the repayment schedule. These loans are characterized by higher interest rates and less favorable terms in order to compensate for higher credit risk.
Proponents of subprime lending maintain that the practice extends credit to people who would otherwise not have access to the credit market. Professor Harvey S. Rosen of Princeton University
explained, "The main thing that innovations in the mortgage market have done over the past 30 years is to let in the excluded: the young, the discriminated-against, the people without a lot of money in the bank to use for a down payment."
, and although covered by privacy law
s the information is readily available to people with a need to know (in some countries, loan applications specifically allow the lender to access such records).
Subprime borrowers have credit ratings that might include:
Lenders' standards for determining risk categories may also consider the size of the proposed loan, and also take into account the way the loan and the repayment plan is structured, if it is a conventional repayment loan a mortgage loan
, an Endowment mortgage
interest only loan, Standard repayment loan, amortized loan
, credit card
limit or some other arrangement. The originator is also taken into consideration. Because of this, it was possible for a loan to a borrower with "prime" characteristics (e.g. high credit score, low debt) to be classified as subprime.
s, Income-Sensitive Repayment
loans Income-Contingent Repayment
loans and so on. Because student loans provide repayment records for credit rating, and may also indicate their earning potential, Student loan default
can cause serious problems later in life as an individual wishes to make a substantial purchase on credit such as purchasing a vehicle or buying a house, since defaulters are likely to be classified as subprime, which means the loan may be refused or more difficult to arrange and certainly more expensive than for someone with a perfect repayment record.
subprime loans are usually classified as those where the borrower has a FICO score below 640. The term was popularized by the media during the Subprime mortgage crisis
or "credit crunch" of 2007. Those loans which do not meet Fannie Mae or Freddie Mac underwriting
guidelines for prime mortgages are called "non-conforming" loans.
A borrower with an outstanding record of repayment on time and in full will get what is called an A-paper loan. Borrowers with less-than-perfect credit 'scores' might be rated as meriting an A-minus, B-paper, C-paper or D-paper loan, with interest payments progressively increased for less reliable payers to allow the company to 'share the risk' of default equitably among all its borrowers.
arose from 'bundling' American subprime and American regular mortgages which were traditionally isolated from, and sold in a separate market from prime loans. These 'bundles' of mixed (prime and subprime) mortgages were the basis Asset-backed securities
so the 'probable' rate of return looked superb (since subprime lenders pay higher premiums, and the loans were anyway secured against saleable real-estate, and so, theoretically 'could not fail'). Many mortgages had a low interest for the first year, and poorer buyers 'swapped' regularly at first, but finally such borrowers began to default in large numbers. The inflated house-price bubble
burst, property valuations plummeted and the real rate of return on investment could not be estimated, and so confidence in these instruments collapsed, and all were considered to be almost worthless Toxic asset
s, regardless of their actual composition or performance.
To avoid high initial mortgage payments, many subprime borrowers took out adjustable-rate mortgages (or ARMs) that give them a lower initial interest rate. But with potential annual adjustments of 2% or more per year, these loans can end up costing much more. So a $500,000 loan at a 4% interest rate for 30 years equates to a payment of about $2,400 a month. But the same loan at 10% for 27 years (after the adjustable period ends) equates to a payment of $4,220. A 6-percentage-point increase (from 4% to 10%) in the rate caused slightly more than a 75% increase in the payment. This is even more apparent when the lifetime cost of the loan is considered (though most people will want to refinance their loans periodically). The total cost of the above loan at 4% is $864,000, while the higher rate of 10% would incur a lifetime cost of $1,367,280.
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, subprime lending (also referred to as near-prime, non-prime, and second-chance lending) means making loan
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
s to people who may have difficulty maintaining the repayment schedule. These loans are characterized by higher interest rates and less favorable terms in order to compensate for higher credit risk.
Proponents of subprime lending maintain that the practice extends credit to people who would otherwise not have access to the credit market. Professor Harvey S. Rosen of Princeton University
Princeton University
Princeton University is a private research university located in Princeton, New Jersey, United States. The school is one of the eight universities of the Ivy League, and is one of the nine Colonial Colleges founded before the American Revolution....
explained, "The main thing that innovations in the mortgage market have done over the past 30 years is to let in the excluded: the young, the discriminated-against, the people without a lot of money in the bank to use for a down payment."
Defining subprime risk
As people become economically active, records are created relating to their borrowing, earning and lending history. This is called a credit ratingCredit rating
A credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government. It is an evaluation made by a credit rating agency of the debt issuers likelihood of default. Credit ratings are...
, and although covered by privacy law
Privacy law
Privacy law refers to the laws which deal with the regulation of personal information about individuals which can be collected by governments and other public as well as private organizations and its storage and use....
s the information is readily available to people with a need to know (in some countries, loan applications specifically allow the lender to access such records).
Subprime borrowers have credit ratings that might include:
- limited debt experience (so the lender's assessor simply does not know, and assumes the worst), or
- no possession of property assetAssetIn financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
s that could be used as securityCollateral (finance)In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
(for the lender to sell in case of default) - excessive debt (the known income of the individual or family is unlikely to be enough to pay living expenses + interest + repayment),
- a history of late or sometimes missed payments (morose debt) so that the loan period had to be extended,
- failures to pay debts completely (default debt), and
- any legal judgments such as "orders to pay" or bankruptcyBankruptcyBankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
(sometimes known in Britain as County Court Judgements or CCJs).
Lenders' standards for determining risk categories may also consider the size of the proposed loan, and also take into account the way the loan and the repayment plan is structured, if it is a conventional repayment loan a mortgage loan
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
, an Endowment mortgage
Endowment mortgage
An endowment mortgage is a mortgage loan arranged on an interest-only basis where the capital is intended to be repaid by one or more endowment policies. The phrase endowment mortgage is used mainly in the United Kingdom by lenders and consumers to refer to this arrangement and is not a legal...
interest only loan, Standard repayment loan, amortized loan
Amortization (business)
In business, amortization refers to spreading payments over multiple periods. The term is used for two separate processes: amortization of loans and amortization of intangible assets.-Amortization of loans:...
, credit card
Credit card
A credit card is a small plastic card issued to users as a system of payment. It allows its holder to buy goods and services based on the holder's promise to pay for these goods and services...
limit or some other arrangement. The originator is also taken into consideration. Because of this, it was possible for a loan to a borrower with "prime" characteristics (e.g. high credit score, low debt) to be classified as subprime.
Student loans
In some countries student loans are considered subprime, perhaps because of school drop-outs. In America, the amount of student loan debt recently surpassed credit card debt. In other countries such loans are underwritten by governments or sponsors. Many student loans are structured in special ways because of the difficulty of predicting students' future earnings. These structures may be in the form of Soft loanSoft loan
A soft loan is a loan with a below-market rate of interest. This is also known as soft financing. Sometimes soft loans provide other concessions to borrowers, such as long repayment periods or interest holidays. Soft loans are usually provided by governments to projects they think are worthwhile...
s, Income-Sensitive Repayment
Income-Sensitive Repayment
There are a number of loan repayment options available to U.S. federal student loan borrowers, including some that are based on the borrower’s income. Income-sensitive repayment lets Federal Family Education Loan Program borrowers decide what percentage of their income their loan payment will be...
loans Income-Contingent Repayment
Income-Contingent Repayment
There are a number of loan repayment options available to U.S. federal student loan borrowers, including some that are based on the borrower’s income. Income-Contingent Repayment is available through the U.S...
loans and so on. Because student loans provide repayment records for credit rating, and may also indicate their earning potential, Student loan default
Student loan default
Defaulting on a student loan in the United States can have a number of negative consequences. To understand loan default, it is helpful to have a few common terms defined:Loan Deferment is a postponement of a loan's repayment...
can cause serious problems later in life as an individual wishes to make a substantial purchase on credit such as purchasing a vehicle or buying a house, since defaulters are likely to be classified as subprime, which means the loan may be refused or more difficult to arrange and certainly more expensive than for someone with a perfect repayment record.
United States
Although there is no single, standard definition, in the United StatesUnited States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
subprime loans are usually classified as those where the borrower has a FICO score below 640. The term was popularized by the media during the Subprime mortgage crisis
Subprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
or "credit crunch" of 2007. Those loans which do not meet Fannie Mae or Freddie Mac underwriting
Underwriting
Underwriting refers to the process that a large financial service provider uses to assess the eligibility of a customer to receive their products . The name derives from the Lloyd's of London insurance market...
guidelines for prime mortgages are called "non-conforming" loans.
A borrower with an outstanding record of repayment on time and in full will get what is called an A-paper loan. Borrowers with less-than-perfect credit 'scores' might be rated as meriting an A-minus, B-paper, C-paper or D-paper loan, with interest payments progressively increased for less reliable payers to allow the company to 'share the risk' of default equitably among all its borrowers.
Subprime crisis
The subprime mortgage crisisSubprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
arose from 'bundling' American subprime and American regular mortgages which were traditionally isolated from, and sold in a separate market from prime loans. These 'bundles' of mixed (prime and subprime) mortgages were the basis Asset-backed securities
Asset-backed security
An asset-backed security is a security whose value and income payments are derived from and collateralized by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually...
so the 'probable' rate of return looked superb (since subprime lenders pay higher premiums, and the loans were anyway secured against saleable real-estate, and so, theoretically 'could not fail'). Many mortgages had a low interest for the first year, and poorer buyers 'swapped' regularly at first, but finally such borrowers began to default in large numbers. The inflated house-price bubble
Real estate bubble
A real estate bubble or property bubble is a type of economic bubble that occurs periodically in local or global real estate markets...
burst, property valuations plummeted and the real rate of return on investment could not be estimated, and so confidence in these instruments collapsed, and all were considered to be almost worthless Toxic asset
Toxic asset
Toxic asset is a popular term for certain financial assets whose value has fallen significantly and for which there is no longer a functioning market, so that such assets cannot be sold at a price satisfactory to the holder...
s, regardless of their actual composition or performance.
To avoid high initial mortgage payments, many subprime borrowers took out adjustable-rate mortgages (or ARMs) that give them a lower initial interest rate. But with potential annual adjustments of 2% or more per year, these loans can end up costing much more. So a $500,000 loan at a 4% interest rate for 30 years equates to a payment of about $2,400 a month. But the same loan at 10% for 27 years (after the adjustable period ends) equates to a payment of $4,220. A 6-percentage-point increase (from 4% to 10%) in the rate caused slightly more than a 75% increase in the payment. This is even more apparent when the lifetime cost of the loan is considered (though most people will want to refinance their loans periodically). The total cost of the above loan at 4% is $864,000, while the higher rate of 10% would incur a lifetime cost of $1,367,280.
See also
- Amortization (business)Amortization (business)In business, amortization refers to spreading payments over multiple periods. The term is used for two separate processes: amortization of loans and amortization of intangible assets.-Amortization of loans:...
- Collateral (finance)Collateral (finance)In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
- Endowment mortgageEndowment mortgageAn endowment mortgage is a mortgage loan arranged on an interest-only basis where the capital is intended to be repaid by one or more endowment policies. The phrase endowment mortgage is used mainly in the United Kingdom by lenders and consumers to refer to this arrangement and is not a legal...
- Graduated paymentsGraduated paymentsGraduated Payments are repayment terms involving gradual increases in the payments on a closed-end obligation. A graduated payment loan typically involves negative amortization, and is intended for young people who currently have low income but foresee a greater future income...
- MicrocreditMicrocreditMicrocredit is the extension of very small loans to those in poverty designed to spur entrepreneurship. These individuals lack collateral, steady employment and a verifiable credit history and therefore cannot meet even the most minimal qualifications to gain access to traditional credit...
- Mortgage loanMortgage loanA mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
- Soft loanSoft loanA soft loan is a loan with a below-market rate of interest. This is also known as soft financing. Sometimes soft loans provide other concessions to borrowers, such as long repayment periods or interest holidays. Soft loans are usually provided by governments to projects they think are worthwhile...
- Student loan defaultStudent loan defaultDefaulting on a student loan in the United States can have a number of negative consequences. To understand loan default, it is helpful to have a few common terms defined:Loan Deferment is a postponement of a loan's repayment...
External links
- J F Bellod, "La Crisis Imposible"
- Wolves Feeding On Bailout NPR.com
- "The subprime wolves are back". Businessweek.
- Workers Say Lender Ran 'Boiler Rooms' Michael Hudson and E. Scott Reckard, Los Angeles Times, Feb. 4, 2005.
- "Sub-Prime Trail of Deceit" The Cleveland Plain-Dealer investigation into the complicity of lenders in the Cleveland foreclosure mess. May 2008
- "From Sub-Prime to Prime-Time - A Debate on the Current Financial Crisis" A panel of economists at Columbia University, School of International and Public Affairs, Feb 28, 2008.